A reporting entity recognizes a loss for construction-type and production-type contracts when the current estimate of total costs at completion of the contract exceeds the total consideration the reporting entity expects to receive. The entire expected loss should be recorded in the period it becomes evident. Management should estimate total consideration by applying the principles in the revenue standard for determining and allocating the transaction price. However, the estimate of total consideration should be adjusted to exclude any constraint on variable consideration in accordance with ASC 605-35-25-46A
and adjusted to reflect the customer’s credit risk. Estimated contract costs should include costs that relate directly to the contract, as provided in ASC 340-40
, including direct labor, direct materials, and allocations of certain overhead costs. Other factors to consider in estimating contract losses include variable consideration (for example, bonuses or penalties), nonreimburseable costs on cost-plus contracts, and change orders that are accounted for as contract modifications (refer to RR 2.9
) in accordance with ASC 606
The lowest level required for determining loss provisions for construction-type and production-type contracts is the contract level, after considering the guidance on combining contracts in the revenue standard (refer to RR 2.8
). However, the guidance permits an accounting policy election to determine the provision for losses at the performance obligation level. Management should apply this election consistently to similar types of contracts.
Example RR 11-14 illustrates the loss provision guidance.
EXAMPLE RR 11-14
Loss contracts - construction contract
Manufacturer enters into a contract to manufacture three specialized construction vehicles over a five-year period. Management concludes the contract is in the scope of ASC 605-35
because of the complex and specialized nature of the machines. At contract inception, Manufacturer anticipates the contract will be profitable. However, in the third year of the contract, due to an unexpected increase in production costs, Manufacturer anticipates the contract will generate a loss overall.
Should Manufacturer record a liability in year three to recognize the anticipated loss on the contract?
Yes. Manufacturer is required to record the anticipated loss in the period the loss becomes evident because the contract is in the scope of ASC 605-35
Question RR 11-8 addresses how to apply the guidance on contract loss provisions to a contract with components both in the scope and out of the scope of ASC 605-35
Question RR 11-8
Manufacturer enters into a contract with a customer that has components in and some components out of the scope of ASC 605-35
. Should Manufacturer apply the guidance on contract loss provisions to the contract as a whole?
If Manufacturer elects to determine the provision for losses at the performance obligation level, we believe that Manufacturer should only apply the loss provision guidance to performance obligations that are in the scope of ASC 605-35
. If Manufacturer elects to determine losses at the contract level, we believe it is appropriate to apply the loss provision guidance only to the portion of the contract that is in the scope of ASC 605-35
. However, given the guidance refers to “contract,” as defined by the revenue standard, we believe other approaches may be acceptable, including applying the guidance to the contract as a whole. Reporting entities should apply a consistent approach to similar contracts and provide appropriate disclosure, if material.